Shake ’em up, Mr Carney

How the Bank of England’s new governor (and the chancellor) should stimulate the British economy

ON FEBRUARY 7th Mark Carney will appear before the Treasury Select Committee for his first formal grilling from British lawmakers since being named the next governor of the Bank of England. This will be an important moment. Mr Carney, hired away from the Bank of Canada, has recently given hints that he wants to shake up British monetary policy. He has talked about the need to stimulate an inert economy until it reaches “escape velocity”; he has said that a central bank might need to “tie its hands” by announcing thresholds to be reached before it reduces stimulus; and he has suggested that the level of nominal GDP—the cash value of output without adjusting for inflation—might be a better target than inflation alone. This willingness to think afresh is admirable. But Mr Carney must now connect the dots between his ideas.

At the moment the Bank of England’s mission, set by the chancellor of the exchequer, is to focus on an inflation target of 2%. That makes sense in normal circumstances. But with short-term interest rates at almost zero, the economy growing at barely 2% in nominal terms (and not at all if you factor in inflation) and many years of austerity ahead, it is worth temporarily reinterpreting that policy and focusing on nominal GDP. Our suggestion is that the bank, backed by the chancellor, George Osborne, should make clear that it will not tighten policy until nominal GDP, currently £1.5 trillion, gets to a level that is at least 10% higher than today.

When short-term interest rates are as low as they are now, central bankers can loosen monetary conditions in two ways. They can use unconventional tools, such as “quantitative easing” (printing money to buy bonds), to push down interest rates further along the yield curve. And they can guide people’s expectations of the future path of interest rates or inflation. If a central bank can credibly promise to keep monetary conditions loose even as the economy recovers and inflation accelerates, it will, in effect, reduce the real level of interest rates today, and so boost the economy.

The Bank of England has been willing to use unconventional tools. It was an early pioneer of quantitative easing; its more recent “funding for lending” scheme for banks is a clever way to bring down banks’ funding costs (and should be used to hit the nominal GDP target). But Britain’s central bank has been less successful at mapping its future policy path. The Bank has interpreted its 2% inflation target in a flexible way, keeping monetary conditions loose even as inflation has stayed higher. But it has not said how long such flexibility will last. Each time its interest-rate-setting committee meets, there is the possibility it will change its mind.

That is where the nominal GDP target comes in. By promising to keep monetary conditions loose until nominal GDP has risen by 10%, the Bank would provide certainty that interest rates will stay low even as the economy recovers. That will encourage investment and spending. At the same time an explicit target of 10% would set a limit to the looseness, preventing people’s expectations for inflation becoming permanently unhinged. It is an approach similar in spirit to the Federal Reserve’s recent commitment not to raise interest rates until America’s unemployment rate falls below 6.5%.

This is not a perfect answer. Critics point out that nominal GDP is hard to measure—and that no one knows exactly how big the shortfall in nominal GDP is, particularly since Britain’s productivity has plunged since the financial crisis. Against that, a 10% increase is a fairly conservative and clear target. Adopting it would be better for the Bank’s credibility than repeatedly missing the inflation target.

Another worry is that all the growth would come through inflation. Sterling would fall, so imports would become pricier. Asset prices might bubble up, though Mr Carney could use other tools to cool them, such as limiting mortgage lending. There is in fact little risk of an unwanted boom. All this will take place as public spending is squeezed and Britain’s main trading partners in the euro zone are likely to be struggling.

The last problem is Mr Osborne. A temporary nominal-GDP target needs his explicit support. He should give it, because against a background of tight fiscal policy, monetary policy is the best macroeconomic lever that Britain has.